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Principles of Finance 2e

Why It Matters

Principles of Finance 2eWhy It Matters
Figure 11.1 In addition to bonds, corporations will often issue common stock as a means of raising necessary capital to finance future operations. (credit: modification of “New York Stock Exchange Huge US Flag Photo i018” by Grant Wickes/flickr, CC BY 2.0)

Chapter Outline

Why It Matters

Similar to bonds, shares of common stock entitle investor owners to a portion of a company’s future earnings and cash flows. However, stocks differ significantly from bonds in how they are issued and managed by companies, the methodology used to calculate their values in public markets, and how they can generate income and eventual value for individual investors.

With common stock, there is no specific promise of how much cash investors will receive or when they will receive it. This differs from bond investments, which are valued entirely on the basis of their guaranteed timing of future cash flows to bondholders.

This means that with stocks, there are no maturity dates, face values, or coupon payment guarantees. It also means that stocks do not promise any specified cash flows in the form of coupons or a face value payment at some point in the future. Instead, stocks (only some, not all) may pay dividends. These dividends are declared after shares of stock have been issued by a company and then purchased by the investing public. Following a dividend declaration, the designated per-share amounts are paid to shareholders of record on a specified date, also determined by a company’s board.

Because stock investments carry no guarantee of payments to investors, they are far riskier than bonds and other forms of fixed-income investments.

While there are many reasons for an investor to choose to purchase common stock, three of the most common reasons are

  • to use stocks as instruments or repositories for maintaining value;
  • to accumulate wealth over the term of the stock investment; and
  • to earn income through capital gains and dividend payments.

As with any financial instrument, common stock purchases offer advantages and disadvantages to investors. Important advantages include the following:

  • Returns through dividends and price appreciation of shares can be substantial.
  • Stocks are a liquid form of investment and can be bought or sold within secondary markets relatively easily.
  • Information about companies, markets, and important trends are widely published and readily available to the investing public.

These advantages are significant and lead many individuals to move into stock investments. Yet it is important to realize that stock has some significant disadvantages, which can include the following:

  • General risk levels are greater than with bonds or other fixed-income investments.
  • Timing the buy-and-sell transactions of stock can be tricky and may lead to losses or not taking full advantage of share price opportunities.
  • Dividends (provided that the stock does indeed pay them, as not all do) are uncertain and subject to change based on decisions of company management.

We will discuss these topics in this chapter and cover many of the details regarding why corporations issue common stock and why investors purchase that stock.

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